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One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We’ll use ROE to examine ASM International NV (
AMS:ASM
), by way of a worked example.
ASM International has a ROE of 21%
, based on the last twelve months. Another way to think of that is that for every €1 worth of equity in the company, it was able to earn €0.21.
See our latest analysis for ASM International
How Do You Calculate ROE?
The
formula for return on equity
is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for ASM International:
21% = 333.616 ÷ €1.6b (Based on the trailing twelve months to September 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity Signify?
Return on Equity measures a company’s profitability against the profit it has kept for the business (plus any capital injections). The ‘return’ is the profit over the last twelve months. The higher the ROE, the more profit the company is making. So, all else being equal,
a high ROE is better than a low one
. That means ROE can be used to compare two businesses.
Does ASM International Have A Good Return On Equity?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. Pleasingly, ASM International has a superior ROE than the average (14%) company in the Semiconductor industry.
ENXTAM:ASM Last Perf February 1st 19
That is a good sign. In my book, a high ROE almost always warrants a closer look. For example,
I often check if insiders have been buying shares
.
How Does Debt Impact Return On Equity?
Most companies need money — from somewhere — to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders’ equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Story continues
ASM International’s Debt And Its 21% ROE
Shareholders will be pleased to learn that ASM International has not one iota of net debt! Its high ROE already points to a high quality business, but the lack of debt is a cherry on top. After all, with cash on the balance sheet, a company has a lot more optionality in good times and bad.
The Key Takeaway
Return on equity is one way we can compare the business quality of different companies. In my book the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So you might want to take a peek at this
data-rich interactive graph of forecasts for the company
.
Of course,
you might find a fantastic investment by looking elsewhere.
So take a peek at this
free
list of interesting companies.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at
.
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